BP's Russian deal makes good sense and the West should be cheering

First, a disclaimer. I have a "day-job". As the strap at the bottom
of this column states every week, I'm chief economist at a company called
Prosperity Capital Management.

Russia can be a tough place to do business

By Liam Halligan

9:00PM GMT 15 Jan 2011

PCM specialises in portfolio investments, buying listed stocks and shares in emerging markets, particularly Russia. We're sizeable players – with $4.5bn under management, having been in business since 1996.

Despite our Russia/CIS-focus, all the money we manage derives from elsewhere – with our client-base made up almost entirely of Western institutional investors such as pension funds, endowments and insurance companies, including many from the UK and US.

I mention all this because of the massive £4.9bn share swap between BP, Britain's biggest company by revenue, and Rosneft, Russia's largest oil major. Given my long-standing professional interest in Russia, and the financial and geo-strategic importance of this link-up, I want to offer comment.

Some readers may turn their noses up at what I'm about to write; a few could even throw personal abuse at me – it wouldn't be the first time – but don't say I'm not being transparent. My company invests in Russia and I've spent a chunk of my adult life working in Moscow. Whether that makes my view more valid, or less valid, is for the reader to decide.

BP produces 3.5m barrels of oil daily – more than 4pc of global production. Rosneft is no slouch either, pumping 2.5m barrels a day. BP has now agreed to swap a 5pc stake in itself for a 9.5pc share of Rosneft, bringing its total Rosneft stake to 10.8pc. In return, the two companies will work together to extract oil from the Kara Sea above Russia's Arctic Circle – one of the world's few oil-rich regions that is largely untapped.

Related Articles

This deal is massive for BP – granting it access to a drilling area as big as the UK's share of the North Sea but with much higher production potential. Russia's Arctic waters may hold 5bn metric tons of oil – 10-times Saudi Arabia's current annual production – together with 10,000bn cubic metres of natural gas – five times Norway's proven reserves.

After the Gulf of Mexico disaster, BP is now back on the front-foot, having deepened its commitment to the world's biggest oil producer. That's right – Russia now pumps 10m barrels a day, more than Saudi. And even without the Arctic, when it comes to gas reserves, Russia is in a league of its own.

The BP-Rosneft deal also has big implications in terms of Western perceptions of Russia – or it should. Rosneft is majority government-owned. So this is the first ever major cross-shareholding agreement between a private international oil firm and a state producer.

Many think the "nasty Russian state" wants to grab control of its oil and gas industry. Well, now a big chunk of Rosneft is being traded with BP. A few months ago, Rosneft agreed to sell off another 25pc of its shares to private investors by 2015 – part of the biggest wave of Russian privatisation since the game-changing voucher auctions of 1996.

Despite Rosneft, more than two-thirds of Russia's oil production capacity is actually privately-owned – by far the highest share of any of the world's major crude exporters. And the private sector's stake in Russia's oil industry just got higher still.

So, this deal should kill both the myth that the Russian oil industry is state-dominated and any notion that "BP has had a terrible time in Russia" – not least through investing in TNK-BP, the country's third largest oil company.

My firm is the largest minority shareholder in TNK-BP. We know the company well, having invested in some of its constituent parts even before the joint-venture was launched in 2003. The reality is that TNK-BP, combining BP's geological know-how with the commercial acumen of the company's Russian partners, has been a spectacular success.

Having invested around £5bn, BP has reaped, on our calculations, around £16-£18bn in dividends from TNK-BP, plus the value of the assets. On today's valuations, having rolled up its sleeves and got seriously involved in Russia, BP has made eight to 10 times its original stake. TNK-BP represents, quite possibly, the best investment in BP's history.

Russia can be a tough place to do business. BP has had to work for its return. The company has fallen out with its TNK-BP partners from time-to-time. Given the oil industry's strategic importance, the diplomatic fur has flown as politicians have waded in to the various rows – Western politicians, by the way, to a much greater extent than their Russian counterparts. Despite the garish headlines, TNK-BP then CEO Bob Dudley never "fled Russia, fearing for his safety", whatever guff BP's spin-doctors fed to Western journalists.

Dudley lost his job as CEO because TNK-BP's other shareholders, as private individuals and institutions looking to optimise their investment, thought someone else would do a better job.

Dudley is now BP's CEO. In his very first major act as the big boss he has, with this Rosneft deal, shackled his company's future to Russia to an even greater extent. Why? Because as Eastern Siberia opens up, as more Russian oil is pumped to fast-growing Asian markets, as the country's punitive oil taxation regime eases, as BP's Russian gas fields come on stream, Dudley knows his company's investments in this vast country provide BP with tremendous opportunities. That's why he wants yet more Russia exposure – something BP shareholders should cheer.

Russia is not for the faint-hearted. As my company well knows, corporate governance abuses remain too common. But despite the difficulties, BP has already achieved major success. The same goes for a host of other Western commercial thoroughbreds that have invested heavily in Russia – including Pepsi, IKEA, Proctor and Gamble, Telenor, Carlsberg, Liebherr, L'Oreal and Auchan. Yes, these firms have had problems, which have been the focus of a great deal of Western media attention. Much less is made of the returns they've made, and the extent to which they're still investing in a country which, within my professional lifetime, will be Europe's biggest economy.

This deal will provoke criticism – not least as BP is now "bid-proof". Had BP not benefited from its TNK-BP dividends in recent years, it would likely have already been swallowed by the mighty US oil major, Exxon. Given Rosneft's backing, such a takeover is now almost impossible – a reality that will incense BP's rivals.

Fingers will also be pointed as Rosneft benefited from the 2002 break-up of Yukos – the oil outfit once-controlled by jailed former tycoon Mikhail Khodorkovsky. Yet to paint Khodorkovsky as a "liberal hero" or a "champion of corporate transparency" is spectacularly simplistic – as my company knows well.

Popular in the West, versions of history presenting Khodorkovsky as "Saint Mikhail" are derided by the Russian public – not least because they simply aren't true.

Oil importing countries – not least the US – should be celebrating this deal. Between 1999 and 2006, Russian oil production grew 60pc. During that period, as Chinese oil consumption grew each year, so did Russian supply. It was only when Russian oil production plateaued above 9m barrels in 2007 that global oil prices span out of control and approached $100 a barrel – as is happening again today.

In the end, the world will wean itself off hydrocarbons – but not for some time.

Meanwhile, despite near-insatiable Eastern demand, the West still needs relatively cheap oil and gas. Russia, of course, has an enormous role to play. That's why, as consumers, shareholders and citizens of the world, we should applaud BP's latest move.